This blog follows geoeconomic and geopolitical developments from the perspective of an Indian investor.

Saturday, April 25, 2009

How much should a Sovereign Borrow? - continued reasoning on the Treasury finances

Chapter 18 of 'Principles of Corporate Finance' authored by Brealey & Myers deals with the interesting topic 'How much should a firm borrow?'. I don't know of any slim volumes in the public domain that present a similar reasoning for Sovereign borrowers. However, King Financing is one of the biggest games in the world. I bet the King Financiers have batteries of private PhDs churning out reams of ring-binded reports to work out the considerations for them. So I'm left to deal with this important topic with my own wits.First of all you need to reason with the different categories of expenses or 'outlays' that a Government has. A Government needs money to provide certain public goods, for which it will collect taxes. For instance, people pay taxes and the collected amounts may be utilized to pay salaries for cops who maintain the law and order. Then you have outlays that are intended to create a long term benefit. For instance, the US Government can provide an economic stimulus for Chinese laptop manufacturers by giving free computers to school kids. The Government hopes that the kid will utilize the computer to pick up various skills, in turn earning a better income when it grows. This will result in a higher income tax collection for the Government in future.It's important to split the Government outlays into items that are like operating expenses they have to provide required public services, and items that are intended to provide a long term return in terms of future GDP expansion and increased future tax collections.The next part of the reasoning is on the interest the Government pays on its outstanding debt. You have to remember that a Government Bond holder isn't a beneficiary in future higher tax realizations of the Treasury. The debt holder simply receives interest and hopefully, the principal back from the Government.The Government financier's interest is to make sure that the interest being paid is out of the money the Government is levying on citizens on an ongoing basis, and not out of the money that is realized from the Government borrowings themselves. A Government debt holder will expect interest to be paid out of the annual earnings of the Treasury. The one year term is derived on the understanding that most levies are collected on an annual basis.From this reasoning, it is clear that on a stand-alone basis a Sovereign can borrow to the extent that the excess of its annual levies over outlays for operating expenses to provide routine public services is sufficiently large to meet interest payment obligations on its outstanding debt.In case of the US Treasury, foreign central banks have a compulsion to lend money to them due to the military-diplomatic hegemonic compulsions. This factor enables the US Treasury to create a 'safety bubble' if it so chooses. Also, the triangular debt trading in the Treasury securities amongst the Treasury, Fed and primary dealers constitutes a method of extracting contributions to Treasury debt through the secret concession embedded in the Treasury Supplementary Financing Account.In this framework, you need to analyze whether the US Treasury interest outgo is coming out of an excess of Treasury Revenues over routine operating expenses or not. If not, the Treasury is completely dependent on foreign central banks for financing. The day China decides to stop buying Treasuries, all other foreign central banks will have no choice but to follow suit, and in this scenario the US Treasury will go bankrupt.To be continued ...